Stripping It Down: Is Las Vegas Boulevard the New Skid Row?
We think that Las Vegas operators face the most treacherous period in the Strip's 68-year history. Since 1990, we have seen a ten-fold increase in capital deployed on the Strip and only a five-fold increase in profits. Even so, the past five years brought about a big run-up in leverage and equity valuations. Unfortunately, the profitability of today's Vegas operators is overly dependant on a foundation of high room rates that is simply not sustainable in the face of the severe consumer pull-back we now confront. Operators that are being forced to aggressively discount room prices to fill their properties are seeing severe negative operating leverage wreak havoc on profitability. Overleveraged and facing dysfunctional capital markets, Las Vegas can ill afford this crippling rate war. While the Street has been aware of these trends for over a year and $90+ billion of public gaming equity has evaporated, we think things are even worse than many perceive. Despite this massive correction, we do not believe we have yet reached bottom. As a result, we have again reduced earnings estimates for the Vegas-exposed operators in our universe and downgrade MGM and WYNN, and reiterated our neutral view on LVS.
- A good story gone bad. It is tough to lose money in the gambling business. In the early 1990s, the dawn of modern Las Vegas, profits and returns were attractive. Over time, the casinos got bigger, fancier, and costlier. Rising profits failed to keep pace with capital spending and returns fell. Cheap debt and equity fueled the fire and by mid-2008 the Strip was exceptionally vulnerable to the severe downturn that arrived.
- A tale of two myths. The run up in leverage and multiples in the post-9/11 era was built on two myths. First was the industry's "recession resistance," its experience in the early 1990s and after 9/11 as gaming seemed immune to the consumer cycle. The second was that Strip properties "weren't in the casino business anymore," as their revenue had diversified away from gambling so their earnings were inherently less volatile. As rooms operations became a major profit source, it was argued that Strip operators should trade at higher lodging-like multiples, not traditionally lower casino multiples. Unfortunately, given the price elasticity of demand in Las Vegas, properties more reliant on rooms revenue than gaming revenue are riskier and more cyclical.
- Room rates, room rates, room rates. While the square footage of casino space on the Strip increased 2.6x from 1990-2008, casino department profits per square foot only grew about 0.6% per year. By contrast, hotel rooms on the Strip increased 2.8x over that period, but hotel department profits per available room grew about 6.4% per year. By 2008, casino operations only generated about 35% of department profits on the Strip, down from 62% in 1990. By contrast, rooms generated 39%, up from 25%. Looked at another way, rooms operations produced almost twice as much of the collective department profit growth on the Strip from 1990-2008 than casino operations did. Given the high operating leverage of rooms operations - both positive and negative - overall Strip profits are now very vulnerable to a collapse in room rates.
- What's next? Las Vegas is now tied to the economy so the economy needs to firm. Assets needed to be re-priced, but the $90 billion of public equity that has been wiped out took care of that. Likewise, gaming must complete the painful de-leveraging process it is currently in. Looking ahead, we think the cost of capital will rise as spreads and equity multiples return to their pre-9/11 ranges. Moreover, we think that in order to be relevant in a post-prosperity society, Las Vegas needs to rediscover the value proposition that it moved away from this past decade. Finally, gaming as a unit growth story is over. Going forward, managements will need to focus on prudent, returns-oriented capital deployment and operational cash flow maximization. Instead of unit growth, free cash flow should be deployed for de-levering, buybacks, and dividends. This will be a dramatic but necessary change in the way gaming companies have operated for the past 20 years, but it will insure gaming's viability.
- Limited equity value left. As we detail in the accompanying reports, this dire situation will pressure the earnings of MGM, LVS, and WYNN. It is hard to find equity value in MGM, so we have downgraded it to Negative. WYNN has a survivor's balance sheet, but it is hard to paint a bull scenario. While we think WYNN is the best of breed among the Las Vegas operators, right now that is a bit like having the nicest cabin on a sinking ship, so we are downgrading WYNN to Neutral. LVS is fairly priced and we remain Neutral.
Wasn't that FUN?